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‘Why are adjusting entries necessary? Surely they cause too much delay in preparing

financial statements, and the financial effect of any entries made is immaterial in the long

run.’ Respond to this criticism.

Adjusting entries are essential to close the books of accounts and reflect true and fair view

of financial positions of an organization to ensure that financial statements are free from any

material misstatements and truly reflect the financial performance of the entity.

Organizations’, which follow accrual system of accounting, ensure that adjustment entries

are passed with respect to assets, liabilities, incomes and expenses so that accounting entries are

posted as per the respective accounting period. In some cases, the size of these entries are not

material enough to impact the financials, yet passing of such entries are essential to reflect true

and fair view. However, in many cases, the size of entries is impactful with respect to accounting

for depreciations, provisions, advances, and many more. The volume of work can be reduced

provided information with respect to accounts and amounts are known prior to closure of

accounting period or accounting date. The organization should design the process in a manner that

all incomes are booked against pre-approved commercials and expenses are booked against

purchase orders. Timely provisions should be made against contractual obligations. In a manner,

regular accounting for adjusting entries can reduce the lead-time required for book closure.
ABC Publishing Ltd sells a monthly political journal on credit. The accounting records at

30th June 2010 revealed the following:

Accounts receivable $ 323,500


Allowance for Doubtful Debts $1,500
The following analysis was obtained with respect to the accounts receivable:

Balance % uncollectable

Accounts not yet due $ 173 600 ½


Accounts overdue: 10-30 days 60 000 2
31-60 days 42 000 10
61-120 days 26 400 25
>= 121 days 21 500 40
$ 323,500
Solution:
Allowance for Doubtful Debts: $21,465

($173,000 *0.5% + $60,000 * 2% + $42,000 * 10% + $26,400 *25% + $21,500 * 40%)

June 30, 2010 Bad Debt Expenses A/c Dr $21,465

Allowance for Doubtful Debts Cr $21,465

(Allowance for doubtful debts has been made based on ageing of receivables)

Allowance for Doubtful Debt


30-Jun-10 To, Balance C/f $22,965 30-Jun-10 By, Balance B/f $1,500
By, Bad Debt Expenses A/c $21,465
Total $22,965 Total $22,965
Bad Debt
30-Jun-10 To, Allowance for Doubful Debts A/c $21,465 30-Jun-10 By, Profit and Loss A/c $21,465
Total $21,465 Total $21,465
Prepare full inventory records (ie a “stock card”) to show the cost of sales for the year and the cost of

the closing inventory, using this format:

Stock Card
Purchases Sales Balance
Date Explanation Units Unit Cost Total Cost Units Unit Cost Total Cost Units Unit Cost Total Cost
1-Jan Opening Inventory 900 $7.00 $6,300.00
6-Jan Purchases 400 $7.05 $2,820.00 1,300 $7.02 $9,120.00
5-Feb Sales 1,000 $7.02 $7,015.38 300 $7.02 $2,104.62
17-Mar Purchases 1,100 $7.35 $8,085.00 1,400 $7.28 $10,189.62
24-Apr Purchase Return (80) $7.35 ($588.00) 1,320 $7.27 $9,601.62
4-May Sales 700 $7.27 $5,091.77 620 $7.27 $4,509.85
26-Jun Purchases 8,400 $7.50 $63,000.00 9,020 $7.48 $67,509.85
11-Aug Sales 1,800 $7.48 $13,472.03 7,220 $7.48 $54,037.82
19-Aug Sales Return (20) $7.48 ($149.69) 7,240 $7.48 $54,187.51
11-Sep Sales 3,500 $7.48 $26,195.62 3,740 $7.48 $27,991.89
6-Oct Purchases 500 $8 $4,000.00 4,240 $7.55 $31,991.89
11-Dec Sales 3,100 $7.55 $23,390.30 1,140 $7.55 $8,601.59
31-Dec Closing Inventory 1,140 $7.55 $8,601.59

Effect of Inventory on Good Stationery’s Income Statement

Good Stationery
Income Statement
for the year ended December 31, 2010
Income
Sales (1000x12 + 700x12.1 + 1800x13.25 + 3500x13.5 + 3100x15) $138,070
Less: Sales Return and Allowances ($265)
Net Sales $137,805

Less: Cost of Sales


Purchases $77,905.00
Less: Returns ($588.00)
Increase / (Decrease) in Inventories $2,301.59
Gross Profit $58,186.41
KLM Ltd purchased new equipment on 1st January 2010, at a cost of $420 000 net of GST.
The company estimated that the equipment had a useful life of 5 years and a residual value
of $45 000. Required assuming a financial year ending 30th June, calculate the amount of
depreciation expense for each year ending 30th June 2010 through to 30th June 2015, with
each of the following methods: (a) straight line; (b) sum-of-years-digits; (c) diminishing
balance using the formula: 1-(r/c)(1/n)
Solution

(a) Straight Line


Depreciation Amount per year
(Purchase Cost – Residual Value) / 5  ($420,000 - $45,000) / 5  $75,000
For the year ending June 30, 2010  $75,000 /2 = $37,500 (Assets purchased on Jan 1, 2010)
For the year ending June 30, 2011 to 2014  $75,000 per year.
For the year ending June 30, 2015  $75,000 / 2  $37,500 (Life ends on December 31, 2014)
(b) Sum-of-years-digits
Remaining
Depreciation
Depreciation Base Life of Depreciation
Year Fraction Book Value
(Cost - Residual) Machine Expense
(A / ∑5)
(A)
2010 $375,000 5 0.17 $62,500 $312,500
2011 $375,000 4.5 0.30 $112,500 $200,000
2012 $375,000 3.5 0.23 $87,500 $112,500
2013 $375,000 2.5 0.17 $62,500 $50,000
2014 $375,000 1.5 0.10 $37,500 $12,500
2015 $375,000 0.5 0.03 $12,500 $0
$375,000

(c) Diminishing Balance Method


r c
Salvage Purchase Depreciation
(1/n)
n Value Cost 1-(r/c) Book Value Expenses
5 $75,000 $420,000 15% $420,000 $61,207
4.5 $75,000 $420,000 32% $358,793 $114,123
3.5 $75,000 $420,000 39% $244,669 $95,111
2.5 $75,000 $420,000 50% $149,559 $74,477
1.5 $75,000 $420,000 68% $75,082 $51,273
0.5 $75,000 $420,000 97% $23,809 $23,050
Limitations of Financial Statement Analysis

Financial Statement Analysis are based on ratios and comparative evaluation. There can be several

things which make calculations of such ratios and comparison difficult:

1. Costs are allocated across several periods basis estimates and ratios can only be accurate

as the estimates.

2. Finance statements are prepared based on cost principle and hence ignore the impact of

price changes, inflation or deflation.

3. Organizations apply different accounting methods while deriving depreciation (Straight

line, reducing balance, sum-of-years-digits), inventories (LIFO, FIFO, Weighted Average)

and others. Hence the comparison becomes difficult and ratios gets impacted based on

methods adopted.

4. Not all intangible assets are recorded in the balance sheet, but expenses incurred to create

such assets are charged as an expense immediately and hence distort the income statement.

Example: brand building expenditure, new product development cost.

5. Management Team may intentionally show better results under undue performance

pressure and hence make the entire financial statement subject to fraud and governance

issue.

6. In case of cyclical industry, comparison become difficult for organizations having different

fiscal year ending.

7. In case of conglomerates or diversified player, it become difficult to classify exact nature

of industry and hence comparison gets difficult and may be misleading.

8. Business condition and circumstances of one year may not be similar to subsequent or past

years and hence comparison and analysis may be futile.